Higher federal taxes, coupled with a rising stock market, threaten to hit U.S. fund shareholders particularly hard.
Indeed, the average “tax drag” on a stock fund — that is, the tax liability that gets passed on to investors each year — climbed to 0.61% last year, from 0.57% in 2008, according to a study that will be released this week by Lipper Inc. While the tax drag remains low by historical standards, it is likely to continue to escalate over the next several years, said Tom Roseen, a research manager at Lipper Inc.
That's because the tax rate on long-term capital gains for households earning more than $250,000 will rise to 20% at the end of the year, from 15%. Add the looming 3.8% flat tax on investment income for high earners, and many investors will see their tax rate jump to 23.8%, Mr. Roseen said. The flat tax, which lawmakers imposed to help pay for health care reform, is scheduled to take effect in 2013.
“This is a really big issue,” he added.
Unlike most corporations, a mutual fund typically distributes all its earnings — capital gains and ordinary dividends — to shareholders each year. This means that fund investors are responsible for paying tax on a fund's earnings whether they take distributions in cash or reinvest them in the fund.
The unwelcome tax news is likely to benefit tax-managed funds that aim to limit their exposure to capital gains distributions.
Offered by a small group of firms — Eaton Vance Corp.,
Fidelity Investments, J.P. Morgan Funds,
T. Rowe Price Group Inc. and
The Vanguard Group Inc. — the funds have not been in great demand recently, because of low taxable distributions.
But with capital gains once again likely to become an issue, providers of such funds believe that financial advisers and their clients may be more receptive to their products.
“We're starting to talk more and more with advisers about the unnecessary performance drag of taxes,” said Duncan Richardson, executive vice president and chief equity investment officer at Eaton Vance, which offers 21 tax-managed funds.
It's certainly a topic that's beginning to resonate more with investors, said Greg Kurek, a fixed-income specialist with J.P. Morgan Funds, an affiliate of JPMorgan Chase & Co.
Investors are slowly beginning to realize that the “easy money” has been made in fixed income, he said.
As a result, investors are beginning to look more carefully at equity funds, and because rising taxes are an issue, tax-managed equity funds should benefit, said Mr. Kurek, whose firm offers the $278.9 billion JPMorgan Tax Aware Disciplined Equity Fund (JPDEX).
“I think tax efficiency is going to be important,” he said.
This will be especially true for retiring baby boomers looking to live off their investments, said Jim Lowell, a partner and chief investment strategist of Adviser Investment Management Inc., which manages more than $1 billion in assets.
As a result, “the whole theme of tax management is more relevant to a greater number of investors, maybe an entire generation of investors, than ever before,” he said.
That said, tax-managed funds may not be the best answer to their needs, said Mr. Lowell, who is also co-founder and chairman of The Rankings Service, a firm that ranks fund managers.
“I don't like them,” he said. “They tend to be gimmicky.”
Micah Porter, president of Minerva Planning Group, disagrees.
“They can work,” said Mr. Porter, whose firm has $60 million under management. “I wouldn't view it as a marketing gimmick. A marketing gimmick is something with no substance behind it; this serves a purpose.”
So how does an investor find the most tax-efficient funds?
Lipper and Morningstar Inc. offer investors tools that can be used to measure tax efficiency.
Within the Lipper Leader Rating System, a Lipper Leader for tax efficiency is a fund that has been successful at postponing taxes over the measurement period relative to similar funds.
The Morningstar Tax Cost Ratio, meanwhile, helps investors better gauge a fund's tax efficiency. The tax cost ratio compares a fund's load-adjusted pretax return to its tax-adjusted return. The resulting number represents the percentage of an investor's assets that are lost to taxes.
E-mail David Hoffman at [email protected].
